Too much debt combined with low commodity prices is in large part what got the E&P industry into its current financial fix. Now, debt has a role to play in helping independents defuse balance sheet crises and take advantage of acquisition opportunities. At Hart Energy’s recent Energy Capital Conference in Austin, a panel of lenders discussed how E&Ps are using creative financing structures to remedy balance sheets, fund acquisitions and more.

Chambers Energy Capital managing director Phillip Z. Pace discussed how the Houston-based investment firm’s flexible debt capital is being put to work for small and mid-sized U.S. independents. Christina Kitchens, managing director and head of national energy finance at East West Bank, Dallas, which in January launched its energy finance group, outlined changes in commercial and regional bank lending and the impact of new OCC regulations. And Brian N. Thomas, managing director of Prudential Capital Group’s Energy Finance Group-Oil & Gas, Dallas, recounted how the company works across E&Ps’ capital structures and stages of development.

Chambers Energy is focused on debt more than equity, although its structures can be “tailored to satisfy the needs of the asset, the owners and the commercial banks, depending on where we are in the cycle,” said Pace. It mainly funds development drilling in the major basins across the U.S., and it has taken an active role in E&P restructurings.

“We also engage in a fair amount of acquisition financing since traditional bank capital is limited by prices or regulators,” Pace added. The average deal size is $25 million to $75 million, with about $900 million in dry powder.

East West Bank has been expanding since entering the energy lending space this past fall. With nearly $34 billion in total assets, the bank has specifically allocated resources to the senior debt energy segment via financings of $5 million to $250 million.

A more hybrid investment approach is the norm at Prudential Capital’s Energy Finance Group, which focuses on private placements for groups involving senior secured and unsecured debt, second-lien debt, mezzanine junior capital and private equity. While the group’s parent, Prudential Financial Inc., maintains in excess of $1 trillion in assets under management, Prudential Capital oversees a private investment portfolio of more than $73 billion, of which some $15 billion involves energy investments. “Because of our size, we have considerable appetite for new investments within the broader energy sector,” Thomas said.

“Prudential Capital Group was created to support the scope and scale of Prudential’s investment interests, and it acts as a direct origination unit that has the capability to source, structure and deploy all forms of private capital needed under one common banner,” he added.

“Our investment platform works with businesses directly or partners with them in collaboration with intermediaries, sponsors or advisors to invest directly in companies. We can be a one-stop capital source for small to middle-market companies, up and down the balance sheet and across the value chain.”

Debt trends

The Energy Finance Group’s role as a capital provider hasn’t changed with the downturn, nor has its investment strike zone, Thomas said. In this environment, for many energy companies senior debt may not be the solution. “Companies that are overlevered don’t need more debt—they need something else. Sometimes it’s more patient junior capital and/or equity, sometimes it’s off-balance-sheet asset partnerships and sometimes it’s the willpower to raise capital through asset dispositions. We’re not seeking to shoehorn the wrong form of capital into situations that merit a different approach. Companies need objective feedback from prospective financial partners.”

The current environment has provided fertile ground for East West to team up with community and regional banks on their performing assets, e.g., those that aren’t distressed and are senior-debt secured, to help lower aggregate energy exposure, said Kitchens. For many of these banks, the requirements of the energy lending space have proven too intensive.

“Teaming up provides them with a longer time period to shore up classified credits with the redirected capital, to free up capital for deployment to other bank growth or new energy clients or to address pressures from bank shareholders or owners,” she said.

Sometimes the community and regional banks want to raise capital to better their reserves in the current environment where they can’t go to the markets; or, if they are publicly traded, perhaps “their stocks are beaten up,” she said. “We’ve discussed with a few institutions assisting with underutilized lines to potentially free up capital and partner up on other earning assets.”

Deal outlook

The deal market is becoming more active. “We have a sizable loan pipeline for largely private-equity-backed transactions on companies that need debt in addition to the committed equity capital to make acquisitions,” Kitchens noted in her discussion of the A&D market.

Pace also addressed deals. “We’re trying to be part of the capital structure there [in acquisition finance],” he said. “We are very focused on good teams and finding a way to invest in the downcycle, as we think the mechanisms are in place to eventually reduce oversupply.”

The cards are on the table for an active 2017 and 2018 in A&D, he added, as banks and bond-holders don’t want to own collateral, and there are a lot of companies working through the restructuring process.

If the acquisition market is to restart, capital is required, Thomas agreed, “but the equity out there is intelligent,” he said. “It’s not there to subsidize a seller’s efforts on assets that are otherwise overvalued under today’s forward price curve. People are waiting for the markets to show confidence that prices are headed upward at a level that supports asset development.

“But at the same time, we have a bank market that is challenged for both existing loans and debt on the balance sheet, and by some of the other structural impediments put in place by the new OCC regulations.

“This is pushing more debt out of the first-lien market into alternative funding sources, so we’re positioning ourselves to help management teams and sponsors address those opportunities on an asset-specific basis.”

At the corporate levels, these deals may involve companies with strong management teams and good assets but a challenged capital structure. “Sometimes, unless you take it all out—which we can and have done—it’s difficult to step in as a capital provider on an M&A event where you have lender fatigue at the first-lien level,” Thomas said. “Some lenders just want out, and the combined pressure of commodity prices and regulatory pressure on banks to reduce exposure and/or commitments is increasingly concerning for both challenged credits and borrowers in good standing.

“You often find this in some of the large syndicate bank groups, that an amendment of a minor issue allows some subset that wants to get out to use that event as an opportunity to hold everything up, to get taken out and drive terms and conditions that are beyond what the borrowers agreed on.

“We may be able to solve it on the balance sheet, or we may have to think about a transaction side-car arrangement, with an asset-specific approach to the capital structure. You may have to start with a clean sheet, without the major creditor issues that tend to frustrate the ability to fund transactions opportunities.”

Exposure and regulations

Another way Chambers is playing the debt opportunity set is as part of reducing commercial banks’ exposure. “There’s plenty of leverage in the system, just look at the high-yield market,” Pace said. Like Thomas, he noted that it’s hard to fix a debt problem with more debt. “So in some instances a preferred instrument can help the banks and potentially minimize dilution of the management team or sponsor backer. That solution can work for development of shale resources or even for mature assets in a traditional, predictable basin that are poorly capitalized for the environment we’re in.”

The new OCC rules are changing up banks’ approaches to E&P lending. “Reserve-based lending as commercial debt is changing materially. It is becoming a “boxed” type of product offering with little structural variability,” Kitch­ens said.

More than 50 E&Ps have filed for bankruptcy since January 2015. Many more are negotiating behind the scenes to avoid the same fate.

In some part this stems from the escalated competition in reserve-based lending commercial debt structures through 2014. “Commercial banks exiting the financial crisis were looking for profitability and asset build-out, and the shale revolution was occurring at the same time. In large measure, they perhaps got out over their skis in seeking this growth avenue,” she said.

Credit migration under the new OCC rules is driving changes for community and regional banks. Those participating in a large syndicated senior debt facility may be particularly impacted when they have high-yield bonds behind junior debt behind their debt capital.

“The senior debt credit classification is cutting deeper than was initially expected because of the wider take on the ‘total funded debt’ or leverage to assets and cash flow,” Kitchens said. Community and regional banks have senior lien preference, and as long as the collateral coverage is there, that was deemed a relatively safe position.

“But with commodity price changes and the more complex debt impacts, these reserve-based lending senior positions are being looked at as less conservative than in the past,” she added.

Based on forecasted bank price deck reductions, falling production and liquidating hedge books, Raymond James estimates that borrowing bases will have decreased 20% to 30% this spring.

The regulations’ blended-debt perspective makes senior debt providers wary of having other debt behind them. “It’s likely that money-center banks, the very large institutions, will want to focus on their higher profit products,” Kitchens said. “So there will be absorption of the senior debt markets by new entrants and regional banks. There will be more stress on large syndications and a pretty significant exit of community banks from the participation space and energy finance as a whole in the near term.”

Another change: The classification of loans’ outstanding balance for commercial banks will be more tied to total proved coverage, with some covenants and cash flow requirements tightened up. “The OCC total funded debt and other advisory might force downgrades more progressively in the near term,” Kitchens said. In the last 30 days and probably through this redetermination season, banks are again reviewing energy credit’s ratings and in some cases having to double downgrade for credits, she added. In other cases, they are determining they were overly punitive in a credit’s migration.

“On the other side of that, through that classification of loans, there is a little more support provided by the regulators’ use of total proved versus having to tie that into risked PDP plus PDNP, which would seem likely in a downturn,” she said.

Having total proved coverage is providing a little better migration of a credit’s classification and its bank’s loss reserves allocation, with the pace determined by collateral coverage, covenant tests and financial performance.

“This is slowing down the process of assets going to the marketplace, when there is sufficient total proved coverage, whereas most prospective buyers are looking for PDP coverage to be the leading indicator of distressed credit’s turnover to assets being marked for sale,” she said.

The new OCC guidelines for how loans are reviewed have a less direct effect on the activities of institutional investors like Prudential Capital, but they have reduced the flexibility of borrowing capacity for some oil and operators, Thomas said. “There is more pressure on properly sizing second liens and the stretch senior piece. Previously, second-lien debt may have represented 40% of the funded debt—now that it may look like 15% to 20% would be the maximum for many looking to conform to regulatory review guidelines, new mezzanine or structured equity may be needed to satisfy senior lenders.”

The new OCC regulations don’t kill the private market’s junior capital, but they do place limits on the magnitude that might be in play and still include conforming bank-led revolving loans, Pace said. Institutions are filling the void, with more nonbanks playing a role.

“At the end of the day, the bank market is not going away completely; it is simply reacting to current market conditions and the potential challenges created by new regulatory guidelines,” said Thomas. The role of the institutional market in providing capital within the energy industry is likely to expand in response. “There are many institutions with patient capital that have considerable experience in this opacity, up and down the balance sheet. We see this as a long term trend.”

Pace weighed in on the challenges thrown up to restructuring. “We track over 200 publicly traded E&P bonds,” he said, “and now funds are being set up to buy bonds to extract greenmail out of a restructuring process. In many instances they have no idea what the business can be or should be, or what the process is, but they have a stake. And they’re going to press the legal framework to see if they can get a settlement and then figure out the business.

“That didn’t exist 10 years ago, and combined with the fact that there is no cash in the system at these prices—it’s a real challenge to get through restructuring. The bank regulators being focused on cash generation is a good thing in the long run.”

In an early April report on the upcoming bank loan redeterminations for E&Ps, Raymond James analysts said, “Look for bank covenant waivers to be relatively attainable, but anti-hoarding covenants will become this spring’s must-have for banks. Based on our conversations with E&P management teams and commercial bankers, we expect covenant waivers will be relatively easy to receive as long as the company is generating positive operating cash flow and has a path to reduce leverage. However, we do expect to see companies overdrawn on their borrowing bases.”

Mentioning the “recent rash of E&P companies fully drawing down their borrowing base,” the analysts said they expect to see more clauses similar to what Denbury Resources recently signed, “limiting the ability of a company to draw down excess cash from its revolver and have it sit on its balance sheet.”

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